Crowdfunding a Poor Investment?

Crowdfunding promises to democratize funding of startups. But is that necessarily a good thing? Entrepreneurial finance experts Josh Lerner, Ramana Nanda, and Michael J. Roberts on the promises and problems with the newest method for funding small businesses.

by Michael Blanding

Working Knowledge

Crowdfunding and the JOBS Act

When Congress passed President Obama’s JOBS Act in March 2012, one of the most intriguing provisions would enable crowdfunding—the ability for large groups of anonymous investors to fund startups. More than a year after the law was passed, however, the provision remains tied up in red tape waiting for the Securities and Exchange Commission to pass rules that would allow for crowdfunding investment on a large scale.

Already, companies have dipped their toes into crowdfunding through websites such as Kickstarter, Indiegogo, and AngelList, with an anticipated $5 million to be raised this year, nearly double the amount in 2012. That’s nothing compared to the bonanza expected when the SEC opens up the floodgates for nonaccredited individual investors to directly acquire equity in private companies—and for companies to directly solicit the public without having to jump through the hurdles usually required in a venture capital presentation.

“A LOT OF COMPANIES THAT PROBABLY SHOULDN’T GET FUNDING WILL GET IT”

As enticing as crowdfunding is as a concept, it may ultimately have little power to shake up the investing world, even as it fills a valuable niche, say three Harvard Business School professors who specialize in entrepreneurial finance.

A TRADITION OF CROWDFUNDING

Before understanding what crowdfunding can do, it’s helpful to understand what it is. In a sense, says Jacob H. Schiff Professor of Investment Banking Josh Lerner, crowdfunding isn’t new—after all, soliciting funds from large groups of people is exactly what nonprofits and political campaigns have been doing for more than a century. In today’s world, though, the Internet has dramatically altered the ability for companies and independent entrepreneurs to get their ideas in front of large numbers of strangers with money to invest.

Associate Professor Ramana Nanda further differentiates between crowdfunding through donations or lending and equity crowdfunding. In the case of donations, which is currently much more common, funders expect little if any direct return. In its most pure form, this is where donations to organizations such as World Wildlife Fund and Save the Children fit in. Those contributing money are driven first and foremost by an affinity with the idea, rather than by any individual reward they might receive. Some websites such as Kiva have pushed this concept further to allow microloans through the crowd to lesser-known microfinance borrowers in developing countries.

Nanda puts most current crowdfunding platforms such as Kickstarter and Indiegogo in the equivalent of the donation or lending category. Kickstarter began as a way for creative individuals—musicians, filmmakers, writers—to fund their work, often with the only return an advance copy of a DVD, concert tickets, or …